Lull in the Small-Cap Sector Could Be an Investor Opportunity

Sure, they've lagged large-capitalization issues for four years and investors are showing little urgency to jump back into the sector.

But in a market environment like this, it's easy for individual investors to overlook three critical facts.

First, some small-caps have done quite well despite the woes of the broad sector.

Second, the sector itself will come back into favor--it always does--and whenever that happens many other stocks will spring to life.

Finally, the best time to find promising small companies is during a lull in the sector, not when it's surging and stock prices are soaring.

With that in mind, The Times ran a computer screen using Market Guide Inc. data that searched for young companies with promising prospects. We turned up 20 names and have profiled five of them below.

The companies operate in a number of industries and the performances of their stocks are just as varied. Some have outdistanced the blue-chip Standard & Poor's 500 stock index in the last 18 months, while others have trailed.

However, they share important traits: all have exceptional sales and earnings records that are projected to continue.

To be included in our list, a company had to have a market capitalization of less than $750 million, the generally accepted definition of a small stock. Many of the companies have far smaller market values.

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We also required that companies show sales and earnings growth of better than 20% annually for each of the last three years. To ensure that the numbers are likely to continue, the companies also had to have expected growth rates in the next three to five years of more than 20% annually.

As for valuation, price-to-earnings ratios on operating profits over the last 12 months had to be less than 40. To be sure, that's a high P/E. But even when small-caps are out of favor, strong companies can carry hefty valuations. And as the list demonstrates, the P/Es of many companies are far less than 40.

We also wanted to see heavy insider holdings, so we required that managers and other insiders own 40% or more of their companies. Extensive insider ownership can be a double-edged sword. In some cases, it lets insiders manage a company with little regard for other shareholders. But more often, a high level of insider holdings spotlights a company that has a huge financial stake in making sure the stock performs.

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Finally, we required that the companies have positive earnings surprises in each of the last four quarters. A positive earnings surprise is no guarantee of future performance. It can be misleading because companies intentionally underplay their prospects so that analysts will set estimates the companies know they can exceed.

Nevertheless, it's far better to have positive surprises than negative ones. Especially in today's climate, where stocks often get pummeled if companies fall even a penny or two shy of estimates, investors want to own companies with track records of making Wall Street happy.

99 Cents Only Stores

A company doesn't have to charge high prices to turn a nice profit.

As its name implies, Commerce-based 99 Cents Only Stores charges but a single price on items ranging from batteries to chocolate bars. Nevertheless, its sales in the last five years have grown at a compound annual rate of 17% and its net income has expanded at twice that clip, according to Deborah Lowenthal, an analyst at Red Chip Review.

The company has succeeded in part because consumers like bargains regardless of how well the economy is doing. And unlike some other bargain retailers, 99 Cents stores are clean, well-lit and attractive, Lowenthal said, features that spur a lot of repeat business.

"99 Cents Stores is doing a good job of getting people to go in there every day," she said. "It's amazing. You say, 'Wow, I'm not embarrassed to shop here. It's bright and clean.' "

The company has 57 stores and management believes Southern California could eventually absorb 200 to 250, Lowenthal said. 99 Cents is opening its first store in San Diego by year-end and might move into Las Vegas, she said.

Central to the company's success is its wholesale unit, which supplies the stores with inexpensive products. The unit buys huge quantities of products at close-outs and also sells to other bargain chains.

In keeping with the nature of its stores, the company is run efficiently and has spartan offices, Lowenthal said.

The company recently completed a secondary offering that increased the number of shares in the public's hands. That could be a positive, Lowenthal said, because it could allow mutual funds, which previously couldn't buy the stock because of its thin liquidity to jump into the stock and push up its price.

One of the only potential negatives is that the stock has had a good run, having risen 42% this year. The P/E of 36 is high and is unlikely to stretch much further. Nevertheless, continued strong earnings from future store openings should help the stock over time, Lowenthal said.

"There's not a lot of multiple expansion left in this story," she said. "But since earnings are growing so strongly we still see stock appreciation."

Cal Dive International

Oil prices have fallen hard recently, but there's still plenty of demand for the services of an oil-related company such as Cal Dive International.

The Houston-based company, which performs a range of underwater oil-field services, specializes in deep-sea work in the Gulf of Mexico. After an oil company has drilled a new well in deep waters, Cal Dive performs such tasks as laying pipes and connecting them to oil platforms. Cal Dive has specialized ships designed for treacherous deep waters.

Cal Dive also does salvage work on aging or abandoned wells.

Though the price of oil has fallen recently, Cal Dive's business should remain strong, said Roger Read, an analyst at Simmons & Co. International, an investment bank specializing in the oil-field services industry.

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Deep-water wells are desirable because they yield large amounts of oil and are efficient to operate, he said. It costs about $5 to extract each barrel of oil pulled from a deep-water well. So even at $14 a barrel, such wells are profitable.

Also, deep-water drilling is a multiyear process and a project is unlikely to be stopped because of a short-term drop in price.

"In the recent downturn in the price of oil, we've seen cutbacks from oil companies on what they're going to spend on land and in shallow waters in the Gulf of Mexico," Read said. "But what we have not seen is cutbacks in deep water in the Gulf of Mexico, where Cal Dive primarily operates."

Nevertheless, the stock is now 26% off its high of more than $40 in early May.

Dura Automotive Systems

Mergers have become an important force in many industries today and the automotive supplier business is no different.

Minneapolis-based Dura Automotive Systems is a leading parts supplier to the auto industry, making such components as gear-shifting systems, parking brakes and hood-release mechanisms. It has a "fairly dominant" position in most of its markets, said Kurt Rivard, an analyst at Robert W. Baird & Co.

It also has aggressively bought out smaller competitors to broaden its product line and increase its efficiency.

Becoming larger helps Dura because large auto makers like dealing with a single company that can provide many parts. The downside is that auto makers don't want to farm out too much work or become too reliant on a single supplier, Rivard said.

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Part of the key to Dura's success is the ability to pull off acquisitions without hiccups, Rivard said.

"The important thing for a company like this is to acquire something and know what you're getting."

The auto industry is cyclical and car sales fall off when the economy weakens. On the plus side, Dura makes core products--as opposed to, say, optional features such as tinted windows--so demand for its products should stay relatively healthy, Rivard said.

Eagle USA Airfreight

It would seem logical that a freight-shipping company must operate its own fleet of trucks and airplanes to make sure it can deliver anywhere and any time.

But Eagle USA Airfreight rejects that logic. The Houston-based company sends its packages on everything from commercial airlines to contracted trucks. That helps the company hold down fixed-asset costs without putting a crimp in its delivery capabilities, said Paul Schlesinger, an analyst at Donaldson, Lufkin & Jenrette Securities Corp.

Lower expenses enable Eagle to undercut its main competition, Emery and BAX Global, on pricing.

"They have much lower fixed costs and much greater flexibility," Schlesinger said.

The theoretical danger is that Eagle would not be able to meet demand during certain peak times, and would therefore lose business to competitors that have in-house fleets. However, that's a remote possibility, Schlesinger said.

FactSet Research Systems

One way to play the stock market is to try to capitalize on broad trends by investing in companies likely to benefit. For example, investors can buy stocks of mutual fund companies during a bull market, figuring their earnings will rise as investors pump money in.

Another way to play the bull market is to buy stock in a company such as FactSet Research Systems, which provides data and financial research to professional money managers.

Greenwich, Conn.-based FactSet has notched strong earnings in recent years and is on course to beat estimates this year with profit above 30%, said Peter Appert, an analyst at BT Alex. Brown. Yet the company hasn't raised prices for years.

How does it manage such strong earnings?

By selling a strong system and complementing it with exceptional customer service, Appert said. Its 95% customer retention rate and almost 26% operating profit margin are impressive.

"The appeal of this business is that it has extraordinarily predictable recurring revenue and is enjoying consistent growth," Appert said.

FactSet increases revenue in three ways. First, the number of companies subscribing to its system is increasing. Second, the number of users at each of those companies is growing. Finally, revenue per customer is rising as FactSet sells them added features.

Revenue should be helped in future years by the company's push into overseas markets, Appert said.

There are two potential downsides for investors.

Though growth has held up even through bear markets, FactSet's stock often gets hit during market downdrafts. The stock, for example, sank from about $33 in late September to about $23 by mid-December amid worries over Asia.

Also, liquidity is thin. Most days, FactSet trades only a few thousand shares. These days, investors aren't rushing to buy stocks that trade so few shares that it can be tough to get out of them.

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Fast-Growing Small Caps: A Sampling

As a group, small-cap stocks have been weak this year. But individually, many have either beaten the broad market recently or sported such strong earnings growth that they may do so in the future. Below are 20 stocks that not only have impressive profit records, but are expected to post strong earnings-per-share (EPS) growth, have reasonable price-to-earnings ratios relative to their growth rates and are heavily owned by insiders: